Jim Reber: Slowing the coaster

rollercoaster

Investors are finding ways to limit prepayment risk in their portfolios.

By Jim Reber, ICBA Securities


It’s beyond trite to describe this year as a roller coaster, but I can’t resist. At the conclusion of the thrill ride (if that’s what 2020 can charitably be called), as the circuit comes to an end, the riders can feel the conductor pumping the brakes. That’s the technique of applying a series of soft “pumps,” versus a hard and sudden stop, to limit the stress on the equipment and the passengers, but to halt the coaster, nonetheless.

In the community banking arena, its equivalent is a strategy to limit the exposure to prepayments that A) amortizing securities possess, which is B) aggravated by the dramatic drop in mortgage rates since March 2020. As we will see, some of these measures can be quite cost-effective. It’s not a stretch to say they can be a major determinant in how well a community bank’s net interest margin weathers the pandemic’s stimulus storm.

Meaningful scale

For many community banks, the returns of their mortgage-backed securities (MBS) will determine the overall bond portfolio’s performance. When we account for all amortizing securities, they are now around 57% of the total.

There are several reasons community banks own more MBS than ever before. One is that the supply of other popular securities is severely limited; in particular, the agency bond population, meaning non-amortizing securities issued by Fannie Mae, Freddie Mac and the Federal Home Loan Bank, is about 40% smaller than in 2007.

Another is that community banks are still right-sizing their tax-free portfolios, following 2017’s tax reform. Tax-free municipal bond holdings have shrunk by about 20% in the past three years. In many cases, community banks have snapped up MBS in their place.


Prepay comparison by collateral type chart


New to the discussion

Of course, it’s no secret that mortgage securities of all manner are on a prepayment tear. Even bonds that would appear to be insulated against “speeding” have been setting records this year. As an example, 15-year Fannie Mae MBS with a stated (“coupon”) rate of 2.5% have been averaging more than 30% constant prepayment rate (CPR) since July, after posting sub-10% CPRs until March.

In response, MBS pool assemblers have been building securities whose underlying collateral has some features, which should be less prone to refinance activity. The most logical variable is outstanding loan balance. Another variable that’s less known, but is no less correlated with slower speeds, is that properties located in New York state are very difficult to refinance. New York state and its counties charge certain taxes on refinancings that can be prohibitive.

New pools are being assembled every day whose collateral is made up exclusively of loans that have, for example, maximum individual loan balances of $150,000, or whose properties are 100% located in New York state.

Using September 2020 as a barometer, we can see the dramatic impact that these certain loan characteristics can produce. In that month, all Fannie Mae 30-year 3% MBS prepaid at an annual rate of 43% CPR, which is a record high.

However, if we look at that same cohort, but with maximum loan balances of $150,000, the speeds dropped to just 15%. As for pools with all New York state properties, the CPR was just 12%. This was the continuation of a trend that began in April.

Investors beware: These specific pools will have higher prices than generics. That’s not a casual comment in a market where five, six and even seven points of premium are commonplace. However, most prepayment models, when applied to the specific loan characteristics, create favorable risk-reward outcomes for these securities, even with the modestly higher prices.

Most community banks’ bond portfolios are currently hurtling along at a breakneck pace. Paying close attention to the collateral of your next MBS purchases can slow things down to a maneuverable pace. Portfolio managers in 2020 are all too glad to pump the brakes on their cash flow.


Webinar series continues

ICBA Securities and its exclusively endorsed broker, Vining Sparks, will conclude its 2020 Community Banking Matters series on Nov. 10 at 10 a.m. CST. Tom Mecredy will discuss M&A and Community Bank Valuation Update. Visit viningsparks.com to register.


Jim Reber, CPA, CFA (jreber@icbasecurities.com), is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks.

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